Foreign Exchange Risk Management and Hedging

The assignment discusses the concept of foreign exchange risk and its impact on businesses. It uses the example of Xinxiang's loss of approx 4% due to currency fluctuations as a result of not hedging. The report concludes that hedging is essential for managing foreign exchange risk, and provides references to relevant studies and literature.

INTERNATIONAL
FINANCE

Table of Contents
INTRODUCTION...........................................................................................................................................3
MAIN BODY.................................................................................................................................................3
(a) Possible Alternative for Managing Risk Exposures in different Scenario-:..........................................3
(b)Recommendations..............................................................................................................................6
(c) Changes in Scenario............................................................................................................................7
(d)(i)Managing Foreign Exchange risk is worth the amount required.....................................................8
CONCLUSION.............................................................................................................................................10
REFERENCES..............................................................................................................................................11

INTRODUCTION
International Finance is a Financial Management in any international business
environment. It is difference as because of there is change in currency in different countries,
changes in political situation, imperfect markets and more diversified opportunity sets
(Nassirtoussi and et.al, 2015). In this report there is discussion regarding international finance.
The report shows contract between an American Company and a Chinese Company where
American Fast Track Inc. had ordered 20 units of rail and to pay the amount in which half of the
amount is paid at time of delivery and half in December 2018. So, as currently the USD is
continue depreciating against Chinese Yuan. So, in this report there is recommendation regarding
different types of Hedging to cover the risks of depreciating value of USD against Chinese Yuan.
MAIN BODY
(a) Possible Alternative for Managing Risk Exposures in different Scenario-:
180 Days
CNY 6.72475/$ ×
1+[2.323 % (100
360 )]
1+[4 %( 180
360 )]
= CNY 6.66944882/$
$25,000,000×CNY 6.66944/$=CNY 166,736,000(Uncertain)
360 Days
CNY 6.72475/$ × 1+2.001 %
1+4.255 % =CNY 6.57936046/$
$25,000,000×CNY 6.57936=CNY 164,484,000 (Uncertain)
Forward Market Hedge

180 Days
$25,000,000×CNY 6.62335/$=CNY 165,583,750
360 Days
$25,000,000×CNY 6.22755/$=CNY 155,688,750
Total
CNY 165,583,750 + CNY 155,688,750 = CNY 321,272,500 (Certain)
Money Market Hedge
Amount to borrow
U.S 180-Days Interest Rate
$25,000,000(1+ 0.04345
2 ) = $24,468,423.50
U.S 360-Days Interest Rate
$25,000,000/(1+0.045) = $23,923,444.9761
Convert the Summed Borrowed
180-Days
$24,468,423.50 ×CNY 6.72475?$=CNY 164,544,030.93
360 Days
$23,923444.9761 ×CNY 6.72475/$ =CNY 160,879,186.603

Invest in China interest rates
180 Days (2.323-2.452%)
CNY 164,544,030 ×(1+ 0.02323
2 ¿ = CNY 166,455,209.85 (Certain)
360 Days (2.001-2.225%)
CNY 160,879,186.603 ×(1+0.02001)=CNY 164,098,379.13
Total:
CNY 166,455,209.85 + CNY 164,098,379.13 = CNY 330,553,588.974
Option MArketing Hedge (Put Option)
180 Days:
$25,000,000 ×0.05 = CNY 1,250,000 (payable)
Borrowing rate of 2.452 %/2 = 1.226%
(1+0.1226)×CNY 1250,000 = CNY1,265,325 (after interest)
$25,000,000 ×CNY 6.65/$ = CNY 166,250,000
Total:
CNY 166,250,000 - CNY 1,265,325 = CNY 164,984,675 (Certain)
360 Days:
$25,000,000 ×0.04 = CNY 1,000,000 (payable)
Borrowing rate of 2.225%

(1+0.2225) ×CNY1,000,000=CNY 1,022,250 (after interest)
$25,000,000×6.25 = CNY 156,250,000
CNY 156,250,000-CNY 1,022,250 = CNY 155,227,750 (Certain)
Total:
CNY 164,984,675 + CNY 155,227,750 = CNY 320,212,425
(b)Recommendations
In this contract where American Fast Track Incorporations that operates a high speed rail
services in U.S had placed an order for purchasing rail cars from the Xinjiang Locomotives of
China in June 2017. They had ordered 20 units of Multi-speed rail cars at the quoted price of
USD2.5 million each, which totals to a payment of USD50 million. So, for the payment process
Xinjiang is worry regarding depreciation of USD against CNY. So, they want to hedge their risks
fir which they had option for taking Forward Exchange Contract or go for purchasing options.
Forward Exchange Contract is an agreement where a business agrees to buy any certain
amount of foreign currency on any specific future dates (Edge, 2017). The purchase rate is fixed
and predetermined. Through entering into this contract the buyer can protect himself from any
subsequent fluctuations in any foreign exchange rates. Mostly intent of this forward contract is to
avoid the position of loss if it occurs because of fluctuations in foreign exchange (Basher and
Sadorsky, 2016).
So in this case where forward exchange contract had been taken they are having overall
loss of CNY.23208, but if they would have not taken this contract they would have loss of CNY
10.4995 Million. So overall they had saved CNY 10.2674 Million by taking forward exchange
contract.
Another option with them of hedging foreign exchange through option contract. The
currency option is a contract wherein buyer gets the right to purchase, but not any obligation for
buying and selling currency at a specified exchange rate before any specified date (Bondarenko,
2014).

Here in this case where if they would have taken call option contract for 180 days on
USD they can have profit in fluctuations of foreign exchange otherwise in all other option they
can have loss. The profit on call option if taken for 180 days would be .09335 per CNY.
So, overall it is better to adopt the hedging of foreign exchange through forward
exchange contract by borrowing and investing.
(c) Changes in Scenario
1.
USD 2,500,000 × 20 units = USD 50,000,000
50,000,000÷2 = 25,000,000 (divided into 2 payments)
Money market hedge (180 days) = CNY 166,455,209.85
Actual exchange rate in Dec 2017
CNY 6.8255 × 25,000,000 = CNY 170,637,500
Actual exchange rate in June 2018
CNY 6.950 ×25,000,000 = CNY 173,750,000
Unrealized gain/loss, Dec 2017 (Hedge 180-Days)
CNY 170,637,500 - CNY 166,455,209.847 = CNY 4,182,290.153 (Gain)
Unrealized gain/loss, June 2018 (hedge 360-Days)
CNY 173,750,000 - CNY 164,098,379.127 = CNY 9,651,620.873 (Gain)
ii) The unrealized gain had occurred because of foreign currency fluctuations and value of CNY
had been appreciated in respect of USD so that is why there is unrealized profit. As the goods are
invoiced in USD, Xinxiang will be receiving the USD as payment from American Fast
Incorporation so if the value of CNY will be increasing they will get more amount then invoiced.
So, the difference Amount after converting currency will be the unrealized profit for Xinxiang
and there will also no loss for American Fast Incorporation as their home currency is USD and
they had to pay USD. The following will the unrealized profit for Xinxiang because of foreign
currency fluctuations in CNY Millions-:
Net amount Payable by AFT at time of delivery-:

$1 6.72475 25 168.1188
If following will be the Forward Rates
Unrealized gain unrealized Gain in
Millions
Forward 180 Days 6.8255 0.10075 2.51875
forward 360 days 6.95 0.22 5.63125
(d)(i)Managing Foreign Exchange risk is worth the amount required
Foreign Exchange risk management is any financial risk that exists because of an
financial transaction which is denominated in any other currency other than home currency of the
company (Hull and Basu 2016). The risk there is regarding the adverse movement in exchanges
rates of denomination currency that is in relation to home currency before the date when any
transaction is completed. As the Xinxiang had exported goods to AFT Incorporation and had
done invoicing in other currency rather than home currency. So there are chances when there can
be fluctuations in the rates of foreign currency which can affect the original profits that had been
earned through selling of the goods. So, there is need for hedging the foreign currency as by
which they can minimize the loss that can be occurred through fluctuations in foreign exchange.
The foreign exchange risk is managed either by using money markets, foreign exchange
derivatives which includes forward contracts, future contracts or even through options and
swaps. So, in this case where the value of USD of Depreciating against Chinese Yuan and
invoices had also been done in USD, if hedging would not had been done they would be having
loss of CNY 14.965 Million which is approximate 4% of total contract value.
$1 6.72475 Loss Payments Loss in CNY
Millions
Forward 180
Days
6.62335 -0.1014 25 -2.535
forward 360
days
6.22755 -0.4972 25 -12.43
-14.965

Calculation of Loss %
Total Contract Value in CNY = USD 50 Million * Spot Rate = USD 50Million * 6.72475 =
CNY 336.238 Million.
Loss = 14.965/ 332.338
Approx. 4%.
As the loss is approx 4% of total contract value which is substantial as the risk free rate of
return of China is also 2.323 and 2.001 respectively. The profit margin for some companies is
equal to this percentage. So, the above amount is substantial and if they will not hedge the will
have high losses.
ii) No, they should not be remain unhedged as they had already as the losses are very much and
substantial so they should not remain unhedged. Examples of Hedging-:
Let's say any person just bought 100 Televisions from a manufacturer in Japan for reselling for
$250,000 and payment had to be done to them in Japanese Yen. By purchasing those televisions
person have created a transaction of foreign risk that is, he could incur any financial loss if any
adverse events take place, in this example that adverse event can be the appreciation or increase
in value of the Japanese Yen when compared with to home currency let’s say the EURO. For
reducing or eliminating his exposure, to loss due a stronger Yen, may engage in hedging
activity. The activity that person undertakes is the purchase of an instrument called a forward
exchange agreement or forward exchange contract (FEC). This agreement is just a types of tools
that are available for effective management of the risk that is of negative exchange rate
movements. As, once the forward exchange contract is carried out, he had eliminated his
exposure and that is therefore referred to as hedged with respect to foreign exchange risk. If he
would not had taken the Forward Exchange contract then are chances he could incur losses
because of that.
Let’s take another example, if he had hedged his 10,000 pounds which he had to pay in future
with the help of Futures contracts, GBP INR or an equivalent, and the exchange rate also went
up from INR 100 per pound to INR 110, then his Futures contracts would have lost 10% of total
value, while his currency would also have gained value. Same will go with the currency
depreciating to INR 88.

CONCLUSION
By summing up above report it suggests that how hedging had helped Xinxiang in saving
some money through Foreign Exchange Risk management. It also suggests that the Xinxiang
must go for hedging as they may save some losses which had occurred because of fluctuations in
foreign exchange. The above report also concludes that the loss which could have been occurred
if they would have taken forward contract will be of approx 4%. This report also sums affects
that could be occurred if Xinxiang would not have taken forward contract.

REFERENCES
Basher, S.A. and Sadorsky, P., 2016. Hedging emerging market stock prices with oil, gold, VIX,
and bonds: A comparison between DCC, ADCC and GO-GARCH. Energy Economics.
54. pp.235-247.
Bondarenko, O., 2014. Why are put options so expensive?. The Quarterly Journal of Finance,
4(03). p.1450015.
Edge, W., 2017. A Balanced Business Approach in Forex Trading . Routledge.
Hull, J.C. and Basu, S., 2016. Options, futures, and other derivatives. Pearson Education India.
Nassirtoussi, A.K. and et.al, 2015. Text mining of news-headlines for FOREX market prediction:
A Multi-layer Dimension Reduction Algorithm with semantics and sentiment. Expert
Systems with Applications. 42(1). pp.306-324.